Investing is a commitment of money with the expectation of receiving even more in the future. The amount you can expect to receive is estimated with a valuation of the investment. And, although it is key, the valuation is the missing link for most individual investors.

Valuation is used to calculate the fair market value or worth of a business, asset, or security. The price is what we pay, and value is what we will get. So, It is essential for investors to estimate the value as well as know the price. And, as important as that is, many, investors use the terms price and value interchangeably.

There are two primary methods of valuation. The market method is a relative valuation where businesses are compared to each other or previous transactions of similar businesses. These comparable analysis are the most frequently used and will be covered first.

The discounted cash flow (DCF) method or discounted dividend model (DDM) are valuation methods that determine the intrinsic value of the business based on cash flow. They are a more thorough approach to valuation but again, require more work.

The intrinsic value of the investment estimates the total money the business and investor can expect to receive from the investment during its remaining life. We’ll cover intrinsic value after comparable values.

#### Valuation is the Missing Link

An estimate of value enables us to invest in a knowledgable and disciplined manner. Without value, we are speculating or gambling; not investing.

Benjamin Graham summarized it well in The Intelligent Investor; *“The intelligent investor is a realist who sells to optimists and buys from pessimists.”*

Optimists and pessimists know the price and can only guess the future. Realists know price and value and can decide a course of action based on the merits of the investment at any price. Realists know the valuation is the missing link to success.

#### But I’m not an Analyst!

To some extent, valuation is the missing link because individual investors avoid the valuation topic. Probably because it is viewed as the complicated domain of Wall Street analysts.

The analysts use discounted cash flow analysis (DCF) to determine the intrinsic value of a stock. However, DCF calculations are complex requiring knowledge of the company, industry, and estimates of future cash flows.

Financial ratios are a simpler way to estimate the value and easier to understand when boiled down to the essentials. And, acquiring familiarity with financial ratios is critical to connect the missing link between what you pay and what you can expect to get back.

The value when compared to the price enables us to buy stocks with a “margin of safety.” The margin of safety is the difference between price and value. So if you pay a price below the value, as you always should, that difference is the margin of safety. It becomes the return on the investment and also helps compensates for potential errors in the estimate of value. It also helps offset any unforeseen negative events.

#### Financial Ratios

The first three financial ratios we cover are Price to Book, Price to Earnings and Price to Earnings Growth. Use these financial ratios to eliminate valuation as the missing link and to help assure satisfactory returns.

#### Low Price to Book Value (P/B):

Price to Book Value is the ratio of the stock market price of the company’s shares divided by its book value of equity. The book value is found on the balance sheet. It is the value of the company’s assets less the liabilities.

Assume company XYZ has $1 billion in assets and $300 million in liabilities with 10 million shares outstanding. The book value would be $700 million ($1 billion assets – $300 million liabilities = $700 million book value). Or, a book value of $70 per share ($700 million book value / 10 million shares = $70/share).

The P/B ratio is an asset-based ratio. It compares a company’s current market price to the net asset value, net worth, or equity value of the company.

Assume XYZ company’s market price is $100 per share. The P/B ratio becomes 1.4 ($100/share market price divided by $70/share book value = 1.4).

Book value is most relevant for companies with significant tangible assets like property, plant, and equipment.

#### Using Price to Book Value

Investors uncover opportunities by finding a low Price to Book Value. A P/B ratio below 1 is a signal that a stock may be undervalued.

If company XYZ stock sells for $25 per share, the P/B ratio becomes 0.4 ($25 per share market price divided by $70 per share book value = 0.4).

In this example, if the XYZ industry’s P/B value averages 1 X then the company shares appear significantly undervalued at 0.4 X.

Benjamin Graham used P/B extensively during the industrial era because companies then owned many tangible assets.

Intangible assets are more prevalent today. Intangible assets include brand names (Coca Cola), intellectual property (Microsoft), or patents (pharmaceutical companies). And, in those cases, the asset-based P/B ratio is not the appropriate measure of value.

#### The Limitations of Price to Book Value

The value of intangible assets are more difficult to determine than tangible assets and subject to more error.

For example, a large goodwill asset may reflect brand name strength that generates earnings. Or, it may simply reflect the overpaid price for an acquisition that will diminish future returns.

P/B like most financial ratios vary with the industry. Capital intensive industries require more tangible assets and tend to trade at lower P/B ratios.

Asset light companies like accounting and consulting firms would typically have higher P/B ratios and less tangible assets. In these cases, where the P/B value is high other valuation ratios should be used.

#### Low Price to Earnings Ratio (P/E)

Calculate the widely used Price to Earnings ratio by dividing the share price by the earnings per share (EPS).

Assume company XYZ stock sells for $25 per share. And, the company earned $1.25 per share over the past twelve months. The P/E ratio is 20 ($25 per share divided by $1.25 earnings per share = 20).

And, since this is based on the last twelve months of earnings it is also referred to as the Trailing twelve months (TTM) P/E ratio or the TTM price multiple.

The “Forward” P/E ratio is based on analysts’ estimates of future earnings. For example, assume an analysts estimate the company will earn, $2.00 per share in the next twelve months.

The Forward P/E ratio is 12.5 ($25 per share divided by $2.00 EPS = 12.5).

#### Using Price to Earnings

Value investors uncover value investing opportunities by finding companies with low Price to Earnings Ratios. A low P/E ratio is a signal the stock may be undervalued.

A low P/E ratio means the investor is buying more future earnings for each dollar invested.

Trailing and Forward earnings are important when valuing a company’s stock. Investors want to know if the company is profitable and how profitable it may be in the future when they actually own it.

A trend of increasing earnings per share will translate into a higher share price if the P/E ratio remains constant. And, additional capital appreciation is realized If the P/E ratio expands.

The P/E ratio varies with the industry. So, it is important to compare the company’s P/E ratio with:

- the company’s own historical P/E, or with
- competitors’ P/Es or with;
- the industry’s typical P/E.

The P/E ratio is useful because it standardizes comparisons of stocks with different prices and earnings. And, it is relatively easy to calculate and widely available on financial reports.

The P/E ratio at a minimum should be in the individual investor’s toolbox to connect the valuation missing link.

#### Low and High P/E Stocks

Low P/E ratio companies are considered “value stocks.” They are often found in mature industries facing setbacks.

The key is to determine if the setback is temporary or permanent. And, if temporary, to act before the market corrects the mispricing.

High P/E ratio companies indicate “growth stocks.” And, the elevated P/E indicates positive expectations of future performance as investors drive up the price.

Investors may still elect to pay the higher price for growth stocks viewing them as a bargain in the context of their future growth. We’ll discuss how to make that determination in the next section.

As with all financial ratios, consider the P/E ratio within the context of value, growth, and industry.

A company’s earnings yield is the inverted price to earnings ratio. It is useful in comparing the return on a stock to the interest yield of a bond. For example, a stock with a 20 P/E ratio has an earnings yield of 5% (1 divided by 20 = 5%).

If AA 20-year bonds yield an interest rate of 6% the stock investor should require a higher earnings yield or lower stock price. This is so the earrings yield more than offsets the additional risk of owning the stock instead of the bond.

#### The Limitations of Price to Earnings Ratio

P/E ratios vary by the industry, the business cycle, and the earnings growth rate of the company.

A company with a P/E of 10 is a bargain. That is unless it is a commodity business at the beginning of a cyclical downturn.

Conversely, a commodity stock with a P/E of 25 is expensive unless it is at a cyclical upturn where earnings will increase significantly.

Determine the cyclical company’s value through the business cycle by normalizing the P/E ratio through the entire business cycle.

Many investors use the P/E ratio because it is readily available. The downside to this availability is earnings distortion due to unusual gains, losses, standard accounting practices and at times manipulation.

P/E ratios only consider the company’s debt indirectly as interest rate expense in the “E.” A company with little debt will is more attractive than a highly levered company with the same P/E ratio.

Investors should adjust for these factors for comparable value estimates.

#### P/E to Earnings Growth (PEG Ratio)

The PEG ratio is useful for adjusting the P/E ratio for the estimated earnings growth of the company.

Lower P/E ratios indicate a better value than a higher P/E ratio. However, if the high P/E company’s earnings are increasing at a faster rate its’ future prospects may be better.

Factoring the company’s expected growth rate into the P/E formula adjusts the results to reflect the growth. The lower the PEG ratio the more undervalued a stock considering its’ earnings expectations.

An example will illustrate this point:

$/share | EPS | P/E | EPS Growth | PEG | |
---|---|---|---|---|---|

Company A | $20 | $2.00 | 10 | 5% | 2.0 |

Company B | $20 | $1.00 | 20 | 40% | 0.5 |

On a P/E basis Company A appears to be a better value than Company B. That is because you can buy $1/year of future earnings for $10 ($20/share divided by $2 earnings/share = $1). However, it takes $20 to buy $1/year of future earnings in Company B.

In three years however, Company A’s earnings/share will be $2.31 ($2 x 1.05^3 = $2.31). And Company B’s earnings/share will be $2.74 ($1 x 1.40^3 = $2.74).

Holding their relative P/E ratios constant Company A will trade for $23.10/share (10 P/E X $2.31 EPS = $23.10/share). And, Company B will trade for $54.80/share (20 P/E X $2.74 = $54.80/share).

The Price to Earnings Growth (PEG) formula better reflects the relative value of companies with significantly different earnings per share growth rates.

#### What we Learned:

- Use both Price and Valuation to estimate the return from an investment.
- Valuation is the missing link, for most individual investors, to successful investing.
- Without the value, we are speculating or gambling; not investing.
- Financial ratios can approximate valuation and are easier to understand.
- Low Price to Book Value (P/B) is useful for companies with tangible assets.
- Price to Book Value has limited use with modern asset-light companies.
- The widely used Price to Earnings Ratio (P/E) is readily available to connect the price and valuation missing link.
- The P/E ratio standardizes comparisons with different prices and earnings.
- The downside is earnings distortion can mislead investors who aren’t careful.
- The PEG adjusts the P/E to reflect different growth rates.

#### Wrapping it Up

In the next article, we’ll discuss the free cash flow price to sales ratios. Then point you to some sources of useful financial ratios for comparison.

References: